11 U.s.c. § 541 and D&o Insurance: an Analysis of the "insured Versus Insured" Exclusion in a Bankruptcy Context Following Indian Harbor

• Publication year: 2020

11 U.S.C. § 541 and D&O Insurance: An Analysis of the "Insured versus Insured" Exclusion in a Bankruptcy Context Following Indian Harbor

Emil Kranz

11 U.S.C. § 541 AND D&O INSURANCE: AN ANALYSIS OF THE "INSURED VERSUS INSURED" EXCLUSION IN A BANKRUPTCY CONTEXT FOLLOWING INDIAN HARBOR

Abstract

Directors and Officers insurance has been a mainstay for most corporations for years. Included in most D&O insurance policies is what is referred to as an "insured versus insured" exclusion which prohibits an insured from filing suit against another insured. Section 541 of the Bankruptcy Code's creation of an estate has created a dichotomy amongst courts plagued with determining whether claims filed by a post-petition debtor or on a post-petition debtor's behalf by a trustee or trust should be covered under a D&O policy including an "insured versus insured" exclusion. The ones most effected by such a trend are not the fortune 500s of the world, but startups and emerging companies which will face stiffer costs leading to a greater likelihood of failure. Basing premiums on the risk a particular insured poses, insurance providers are likely to increase premiums in an uncertain legal environment. Couple this with the likelihood of an economic correction on the horizon, and a trend of increased premiums is ever more likely.

This Comment first looks at the history of D&O insurance and the emergence of "insured versus insured" exclusions. Next, this Comment offers a microcosm of the current dichotomy amongst courts, by examining the majority and dissenting opinions of Indian Harbor Ins. Co. v. Zucker. Second, this Comment analyzes exceptions to "insured versus insured" exclusions that have been making their way into D&O insurance policies and how courts have historically treated claims brought by debtors in possession compared to claims brought by trustees. This Comment concludes by proposing a four step approach courts should take when tasked with determining an "insured versus insured" exclusion's applicability. Step four of the approach includes a recommended "Modified Factors Test," which builds on a similar concept first suggested years ago by Michael D. Sousa.

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Introduction

Directors and Officers liability insurance, often referred to as D&O insurance, covers director and officers for claims against them during their time serving on a board of directors or as a corporate officer. D&O insurance continues to be a mainstay for most corporations in the aftermath of the 2008 financial crisis and beyond. With the frequency of securities class action lawsuits increasing steadily from 2011 through 2015, the likelihood of a corporation facing such a suit is the highest it has ever been.¹ Corporations in the life sciences and technology industries have felt the brunt of these suits.² With a greater likelihood of corporations facing a lawsuit, inconsistency amongst courts as to how to treat certain provisions within a D&O policy (in this case following a bankruptcy filing by the insured company), comes with inconsistency in determining the risk of litigation a particular company poses. Without a more consistent approach, insurance companies will likely raise premiums on corporations taking out D&O insurance policies. Companies operating at low margins, most notably, startups and smaller organizations, will face the greatest impact. Increased premiums which cause these companies to forego D&O insurance due to fiscal concerns could result in qualified individuals becoming reluctant to accept directors, officers, or board positions out of fear of being personally liable down the line. Such reluctance could result in a chilling effect—slowing startup growth and stifling innovation.

The concept of D&O insurance began in the 1930s in the wake of the Great Depression, following the inception of the U.S. Securities Act and the Investment Company Act.³ However, it was not until the 1970s that D&O insurance became commonplace, a consequence of increased litigation against the boards of corporations in the late 1960s.⁴ D&O's "fundamental purpose [being] to shift by contract to an independent third party—the insurance carrier—a portion of the risk arising out of actions taken both by the corporation's officers and directors in their official capacity and by the corporation itself in connection with securities law matters."⁵

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Commonplace within a D&O insurance policy is what is known as an "insured versus insured" exclusion.⁶ "[A]n 'insured versus insured' exclusion bars coverage [by an insurer under an insurance policy] for claims made by one insured under the policy, for example, the corporation, against another insured under the same policy, for example, the corporation's directors and officers."⁷ Although questions surrounding the applicability of the "insured versus insured" exclusion typically arise in the context of derivative suits,⁸ so too can it become an issue in bankruptcy.⁹ To this point, a circuit split exists regarding the issue of whether a lawsuit brought against a corporation's former or current directors and officers brought by a debtor in possession, trustee, creditors' committee, court-appointed trustee, or post confirmation liquidating trustee, triggers the "insured versus insured" exclusion in a D&O insurance policy held by a corporation. The Third, Fourth, Sixth, Eighth, and Ninth Circuits concluded that an "insured versus insured" exclusion bars coverage when a post-petition entity files suit against directors and officers covered under a corporation's D&O insurance policy.¹⁰ In contrast, the First, Second, Fifth, and Eleventh Circuits concluded that an "insured versus insured" exclusion is not applicable in the aforementioned circumstances.¹¹ The Seventh Circuit declined to rule on the issue;¹² the Tenth Circuit has yet to be tasked with the issue.

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Representing a microcosm of the current split is the 2017 Sixth Circuit case Indian Harbor Ins. Co. v. Zucker.¹³ In reaching a split decision, the majority and dissent in Indian Harbor argue that contradicting applications of 11 U.S.C. § 541(a) exist when determining whether the creation of an estate under bankruptcy law should constitute a wholly separate entity for purposes of an "insured versus insured" exclusion.¹⁴ Indian Harbor will be explored in greater detail infra.¹⁵

For purposes of an "insured versus insured" exclusion's application to bankruptcy law, it must first be established whether language in the applicable D&O insurance policy includes an "insured versus insured" exclusion and if such inclusion includes any expressly stated exceptions. If the D&O insurance policy contains an "insured versus insured" exclusion and does not contain an express exception for post-bankruptcy entities or trustees, then it is important to determine whether a debtor in possession or a trustee is bringing the suit. As will be discussed, courts seem to agree that if a debtor in possession is bringing the suit, too strong a potential for collusion is present, barring the suit under the "insured versus insured" exclusion. However, the same level of agreement amongst courts is not present when a trustee is bringing suit. As such, when a trustee brings suit, a case-by-case analysis must be conducted to determine if a trustee is acting on behalf of the prepetition debtor to such an extent that would warrant the exclusion's applicability.

Part I of this Comment will provide an overview of D&O insurance and how it came to be commonplace from its creation in the 1930's to its usage today. Part II will provide a background on the "insured versus insured" exclusion and its controversial past. Part III will provide an overview of Indian Harbor, describing the background to the case and both the majority and dissenting opinions. Part IV analyzes what must be considered when determining the applicability of an "insured versus insured" exclusion in the bankruptcy context, including the differing approaches when express language is provided in a D&O insurance policy and the differing treatments of suits brought by debtors-in-possession and trustees. Finally, Part V reinforces the multi-factor approach suggested by Michael D. Sousa in his 2007 Comment for the Emory Bankruptcy Developments Journal, "Making Sense of the Bramble-Filled Thicker: The Insured vs. Insured Exclusion in the Bankruptcy Context" with some additional recommendations based on twelve additional years of case law.

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I. An Overview of Directors & Officers Insurance

Directors & Officers insurance, or D&O insurance for short, has been a way for businesses to "shift by contract to an independent third party—the insurance carrier—a portion of the risk arising out of actions taken both by the corporation's officers and directors in their official capacity and by the corporation itself in connection with securities law matters."¹⁶ D&O insurance policies have typically helped shield organizations from claims against its directors and officers for things such as fraud, mergers, breaches of fiduciary duties,¹⁷ and inadequate or inaccurate disclosures. In fact, it has been said that "D&O insurance plays an important role in corporate governance in America" because "[u]nless directors can rely on the protections given by D&O policies, good and competent men and women will be reluctant to serve on corporate boards."¹⁸ This role is ever more important in filling in the gaps when indemnification is unavailable.¹⁹

A typical D&O insurance policy consists of two types of coverage, Side A and Side B.²⁰ Side B coverage provides the protection for the corporation.²¹ Side B coverage "compensates a corporation for expenses that it incurs as a result of indemnifying directors and officers and that, in the absence of insurance, would have to be paid out of corporate funds."²² Side B coverage's relevance to the "insured versus insured" exclusion is that it makes the corporation an insured under the policy, filling...